One Retailer Thrives by Selling the Right Things in the Right Places

Retailing is a difficult industry, and it takes more than great shopping experiences and low prices to survive and thrive. As a specialty value retailer targeting teen and preteen customers, Five Below (NASDAQ: FIVE) has learned from retail giants like Costco Wholesale (NASDAQ: COST) and Wal-Mart Stores (NYSE: WMT) , working on its merchandising and store expansion strategies to its advantage.

Merchandising strategyFive Below is a retailer caught in a classic catch-22 situation. On one hand, it must adopt the cost competitiveness of dollar stores, as it sells merchandise priced at $5 or below to younger customers with lower purchasing power. On the other hand, Five Below has to fulfill expectations of being a specialty teen retailer by offering high-quality and trend-right products. Despite the challenges, it has managed to successfully blend together elements of both low-cost and differentiation strategies.

With respect to cost efficiency, Five Below minimizes the number of SKUs (stock keeping units) to drive profitability. Its stores stock an average of about 4,000 SKUs across various product categories. This is similar to the merchandising strategy of Costco, the pioneer of the warehouse-club concept, which carries about 3,700 SKUs per warehouse.

As a result of this 'shallow' merchandising strategy (limited number of SKUs per product category), both Five Below and Costco sport healthy inventory turnover ratios. While Five Below's 2013 inventory turnover of 5.4 times is lower than that of Costco (12.3 times), it is sufficiently decent for a specialty retailer.

In addition to reducing inventory-holding costs, stocking fewer SKUs allows Five Below to adopt an opportunistic buying strategy, which is a critical factor in the purchasing of in-trend merchandise. Five Below makes sure that it offers its teen customers the 'hottest' products on the market by quickly clearing dated items off its shelves and replacing them with new, trending ones. This is validated by the fact that Five Below sends new merchandise to its stores regularly -- between two and four times a week.

Unique products are also a key crowd puller. While Costco depends heavily on private-label products to build up its brand equity, Five Below relies on licensed merchandise from Star Wars, Hello Kitty, and Transformers to keep its customers loyal. In this way, Five Below leverages on the branding power of these well-known characters and icons.

Store clustering strategyDue to the localized nature of retail, there are limited advantages to owning a national footprint. Despite this, many retailers have been led astray by their ambition to transform themselves from a small-town monopolist to a national player. Five Below is one notable exception. While it runs about 300 stores in the U.S., the stores are concentrated in 19 states in the Eastern half of the U.S. rather than dispersed across the country.

Five Below has followed a prudent strategy of saturating its existing markets first before expanding into new markets. In 2011, it expanded to Chicago and Detroit; Austin, Texas and Dallas were Five Below's new target markets in 2013. Even in the new markets, the store-clustering strategy is applied to its fullest by opening multiple stores in a single market on the same day.

This is exactly what Wal-Mart did before it became the world's largest retailer. While Wal-Mart's overall revenue and earnings are much higher than what they were decades ago, its profitability in terms of margin is lower because Wal-Mart isn't the market leader in some of the foreign countries and local markets it operates in. Wal-Mart's founder Sam Walton established the company's dominance and market leadership in small towns in Arkansas before expanding operations nationwide. Similar to Five Below, Wal-Mart made sure it had sufficient stores in Arkansas to meet all of the demand prior to its expansion to adjacent markets.

Both Five Below and Wal-Mart (in its early days) enjoyed the following advantages associated with market concentration.

Firstly, it increased brand awareness. The greater the number of Five Below and Wal-Mart stores you see in your neighborhood, the more likely the brand will stick in your mind.

Secondly, both retailers benefited from local economies of scale in advertising and distribution. An ad in the local daily costs the same regardless of the number of stores and customers that Five Below and Wal-Mart have in a single market. Five Below currently relies on only two distribution centers to ship goods to its 300-plus stores. Had it chosen to have a string of stores scattered across the U.S., Five Below would have incurred significantly higher costs to build a sufficient number of distribution centers to support square footage growth.

Foolish final thoughtsSuccessful retailing is all about selling the right products in the right places. In that regard, Five Below has learned from masters like Costco and Wal-Mart with great success.

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